In recent days, the markets have hit new all-time highs. With investors getting excited, many expect the run-up to continue. Sentiment is increasingly positive, and the fear of missing out is becoming a powerful driver for nervous investors to get back in the market. But should they?
The best way to figure that out is to look at the conditions that have caused the current records and try to determine whether they are likely to continue. Here, there are three factors that I think are most important.
Low Interest Rates
Even as the stock market is at all-time highs, interest rates are close to all-time lows. This scenario makes sense, as lower rates generally equate to more valuable stocks. As such, this is indeed a condition that has supported values. Looking forward, though, there simply is very little room for rates to keep dropping. More, with the Fed now looking to get inflation back to higher levels—and quite possibly on the verge of explicitly endorsing higher inflation for a time—the possibility of higher rates is real, although likely not immediate. Even in the best case, this is one tailwind that looks to be subsiding, which should limit any further appreciation even if it does not turn into a headwind.
Growth Stock Outperformance
The majority of the stock market’s records come from a handful of tech stocks. These companies have disproportionately benefited from the COVID shutdown, and they have been one of the few growth areas of the market. As the virus comes under control, that tailwind will fade. More, since these companies are such a disproportionate share of the stock market as a whole, slower growth there could bring the market down by much more than the actual slowdown in growth. Again, we have a situation where a tailwind is fading, which could bring markets down even if that tailwind never actually turns into a headwind.
Natural Limits?
It is not just stock prices that are at all-time highs; other valuation metrics are as well. While price-to-earnings multiples are very flexible, other ratios provide less room for adjustment, and they are very high. The ratio of the stock market to the national economy, known as the Buffet indicator since Warren Buffet highlighted it, is at all-time highs. Can the stock market keep growing as a percentage of the economy as a whole? The price-to-sales ratio is showing the same thing. No tree grows to the sky. Once you get above the highest levels of previous history—which in both cases are those of the dot-com boom—you have to ask how much higher you can get. Is it really different this time?
Not an Immediate Problem, But . . .
Markets are known to climb a wall of worry, and there are certainly many worries out there that are more immediate than the ones I have highlighted above. None of these issues is likely to be the one that knocks the market down. But taken together? They do create an environment that could make for a substantial downturn.
As regular readers know, I have been relatively positive about the COVID pandemic, recognizing that it could and, eventually, would be brought under control. Similarly, I have been relatively positive about the economic recovery. Despite some concerns, I still hold that position. We will discuss why in more detail later this week.
Risks Ahead?
For the market, however, all that positive sentiment (and then some) is now baked into prices. That doesn’t mean that a downturn is likely any time soon. It does mean that we should not get caught up in the excitement. All-time highs are great, and they often lead to further highs. But they can also signal increased risk. Let’s keep that in mind as we look at our portfolios.
Editor’s Note: The original version of this article appeared on the Independent Market Observer.
